Climate Change and Macroeconomic Outcomes in Low-Income Countries
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1 Climate Change and Macroeconomic Outcomes in Low-Income Countries Alessandro Cantelmo International Monetary Fund Chris Papageorgiou International Monetary Fund October 27, 2017 Giovanni Melina International Monetary Fund Preliminary and incomplete Abstract Climate change poses a challenge on policymakers of low income countries LICs) in achieving convergence with advanced economies subject to the constraint of limiting emissions. In addition, those countries are the most exposed to natural disasters and extreme weather events. Using a dynamic stochastic general equilibrium model of a LIC, we highlight the effects of weather shocks on economic growth and debt sustainability of such a country. We employ different Representative Concentration Pathways RPCs) to generate projections of the cumulative effects of climate change on macroeconomic aggregates, in particular on per-capita GDP and public debt, up to the year Rising temperatures increase both the probability and the magnitude of weather shocks thus dampening economic growth and worsening the debt position of LICs. Fiscal policies aimed at coping with weather shocks, jointly with climate policies and public debt management bring growth and public debt projections to acceptable levels. JEL classification: E22, E62,F34, F35, H54, H63, H84, O23, Q54.. Keywords: Climate change, weather shocks, debt sustainability, low income countries, DSGE, fat-tail risks. We acknowledge funding from the U.K. Department of International Development DFID). The views expressed in this paper are those of the authors and do not necessarily represent those of the International Monetary Fund, IMF policy or DFID. Research Department, International Monetary Fund, th Street N.W., Washington, D.C , United States. addresses: acantelmo@imf.org, gmelina@imf.org, cpapageorgiou@imf.org. 1
2 1 Introduction One challenge that climate change poses on policymakers of low income countries LICs) is to achieve convergence with advanced economies subject to the constraint of limiting emissions. This might entail higher costs and possibly dampen growth see, e.g. Llavador et al., 2015). In addition, these countries are usually very exposed to natural disasters and extreme weather events that cause high economic as well as human losses. Moreover, there is a somewhat widespread agreement that the rise in temperature over the coming years global warming ) will likely make these events more frequent and more powerful see, e.g., IPCC, 2014). Growth policies in these countries are deeply linked to their fiscal sustainability. Small developing countries need to rely on foreign private investments as well as public debt to grow, and at the same time, they need to insure themselves against negative weather events see, e.g. Marto et al., 2017). Global warming will likely increase the frequency and the magnitude of these events thus posing a threat to macroeconomic outcomes of developing countries and, ultimately, on their public debt sustainability. We therefore assess: i) the effects of global warming on the most important macroeconomic aggregates and on the sustainability of public debt in countries exposed to extreme weather events, for different projected paths of temperature; ii) policies those countries might implement to achieve sustainable growth and resilience to extreme weather events. We follow IMF 2017) and Marto et al., 2017) and use the Debt, Investment and Growth DIG) model Buffie et al., 2012) to study the long-run effects of climate change and draw policy implications on LICs. Indeed, the DIG model is a dynamic general equilibrium DGE) model more suitable than existing Integrated Assessment Models IAMs) as it accounts for several peculiar features of LICs. However, these contributions analyze such issues in a perfect foresight environment, in which either the weather shock that materializes is known to the agents Marto et al., 2017) or the path of temperature affects TFP according to a deterministic process IMF, 2017). Conversely, we analyze a stochastic environment, hence a dynamic stochastic general equilibrium DSGE) model, in which both the probability and the magnitude of the weather shock will be increasing in temperature, thus also accounting for fat-tail risks. In this sense, our environment is closer to the notion that climate change implies a shift of the stochastic distribution and the one in which weather events are more frequent and more powerful, as predicted by the majority of scientists and empirical studies of climate change see, e.g., IPCC, 2014). In addition, while Marto et al. 2017) consider a specific natural disaster and evaluate policies after it has occurred, and then assess how lower the damages would have been with higher adaptation, we take a different angle and consider the cumulative effects of climate change in the long-run on per-capita GDP and public debt, and how fiscal and climate policies affects the distribution of these macroeconomic outcomes. We use projections of temperature up to the year 2100 and analyze debt sustainability and policy options over such a long horizon, under different Representative Concentration Pathways RPCs) scenarios and show that the distributions of per-capita GDP and public debt to GDP are negatively affected by 2
3 higher temperatures and weather shocks. Engaging in climate policies aimed at limiting or reducing emissions decreases the frequency and magnitudes of weather shocks thus alleviating debt distress of LICs and leaving more fiscal space which is crucial to implement growth friendly policies. In addition, fiscal policies such as investment in adaptation capital will help LICs mitigating the damages of weather shocks. The remainder of the paper is organized as follows. Section 2 presents the DSGE model while Section 3 discusses its calibration. Results are presented in Section 4 and Section 5 concludes. 2 The model We introduce a two-sector small open economy model featuring a traded and nontraded goods sectors along the lines of Buffie et al., 2012). Sectors are disparately affected by a natural disaster while the government has alternative public financing instruments domestic and external debt, grants, and consumption taxes) to implement growth policies and cope with natural disasters. There are five channels through which the economy is impacted by the natural disasters: i) through permanent damages to public infrastructure; ii) permanent damages to private capital; iii) temporary losses of productivity resulting from the economic and social disruption e.g., people are not able to work and have to spend time removing debris); iv) increased inefficiencies in public investment during the reconstruction period; and v) damages to the sovereign s creditworthiness. 2.1 Firms Firms produce tradable and nontradable goods y x and y n, respectively) according to a Cobb-Douglas production technology combining public infrastructure a constant elasticity of substitution CES) function of standard infrastructure z i and adaptation capital z a with productivity ν a with private capital k j and labor l j. Firms operate in one single sector and benefit from a sector-specific total factor productivity TFP) A j. The natural disaster affects both sectors, but causes disparate damages D j [0, 1] to output by permanently destroying public and private capital and resulting in a transitory loss of productivity. The impact of the natural disaster can however be counteracted by public investments in adaptation activities that reduce the extent of the damages with π j and ν D being scaling factors). In each sector j, a firm maximizes profits according to Φ j,t = P j,t 1 D j,t 1 + π j z a t 1) ν D ) y j,t w t l j,t r j,t k j,t 1, 1) where w is the economy-wide wage and r j is the sectoral return on capital in sector j. 1 1 Labor is perfectly mobile hence the wage is the same across sectors while returns on private capital are sector-specific, except in the steady state. 3
4 Sectoral output is defined as and public capital as y j,t = A j,t z ψ j t 1k α j j,t 1l 1 α j j,t, for j = n, x 2) z t = [ ρ 1 ) ξ 1 ξ z z i ξ t ] ξ + 1 ρ z ) 1 ξ νa zt a ) ξ 1 ξ ξ 1, 3) where ρ z is a weight parameter and ξ is the intratemporal elasticity of substitution between public capital inputs standard and adaptation). This functional form is particularly useful in discussing adaptation because it allows us to view it either as a substitute or a complement to standard infrastructure e.g. seawalls vs. climateproofing roads; see discussion in the calibration section). Note that damages can be decomposed into damages to public and private capital as well as losses of productivity according to ) ) 1 D zj = 1 D ϖz j 1+π j z a ) ν D, ) ) 1 D kj = 1 D ϖk j 1+π j z a ) ν D, and ) ) 1 DAj = 1 D 1 ϖzψ j j ϖ k α j 1+π j z a ) ν D, respectively. The severity of the damages to public and private infrastructures is controlled by ϖ z and ϖ k, respectively, such that the larger ϖ z is, the greater public infrastructure was destroyed relative to private capital and TFP with 1 ϖ z ψ j ϖ k α j 0). The literature on natural disasters distinguishes damages from economic losses. We thus target the size of D Aj as representing economic losses and D zj and D kj as damages to physical infrastructure. The disruption in the functioning of public and private infrastructure has a persistent effect on the TFP because infrastructure takes some time to rebuild and workers may have spend to their time cleaning roads or rebuilding their houses, so aggregate productivity is assumed to recover slowly. Profit-maximizing firms demand capital and labor according to y j,t P j,t α j = r j,t, 4) k j,t 1 P j,t 1 α j ) y j,t l j,t = w t, 5) for j = n, x. Output elasticities with respect to total public capital can also be derived as P j,t ψ j y j,t z t 1 = R z t, 6) where R z t is the total return to public infrastructure, which can be expressed in ) 1 terms of the returns to standard and adaptation infrastructure as Rt zi z i ξ t 1 ρ zz t 1 and R za t ) ν 1 ξ a zt 1 a 1 ξ 1 ρ z)z t 1, respectively. Note that firms do not take into account the added benefit of adaptation namely the protection against natural disasters) in their optimal decisions and only factor in the benefits of having additional infrastructure as an 4
5 input in their production processes. Infrastructure prices are a function of the price of the imported machinery needed to produce capital, P mm, and of the price of the a j j = k, z i, z a ) nontradable inputs needed to produce capital P n. The price of private capital is given by P k,t = P mm,t + a k P n,t. We allow public standard and adaptation infrastructures to have different imported and nontradable input contents to reflect the idea that adaptation infrastructure requires more technical inputs provided externally and sold at a premium pr or that they demand more or less construction materials than the standard infrastructure. The prices of standard and adaptation infrastructure are thus given by P z i,t = P mm,t + a z ip n,t and P z a,t = 1 + pr) P mm,t + a z ap n,t, respectively. 2.2 Government Government expenditures are directed to investments in standard and adaptation infrastructure i z i and i z a, transfers to households Υ, and servicing public domestic and external debt. The government also collects revenues from VAT on households consumption and from fees on Ricardian households usage of standard public infrastructure as a fraction f of recurrent costs δ z ip z i 0 involved in the maintenance of the infrastructure, i.e. µ = fδ z ip z i 0 ). 2 As Dabla-Norris et al. 2012) show, infrastructure stocks vary considerably in lowincome countries despite high levels of investment. Therefore, the economy only benefits from effectively produced capital, which depends on public investment efficiency s [0, 1]. The public investment process is equally bureaucratic and inefficient across the two capital inputs. To account for the increased inefficiencies that arise postdisaster, s is time-varying and affected by D s at the time of disaster. In particular, the ability to transform each dollar spent into capital takes some time to recover, with expenses being lost in non-productive activities. Public capital therefore evolves according to z i t = 1 δ z i) z i t D s ) s t i z i,t, 7) z a t = 1 δ z a) z a t D s ) s t i z a,t. 8) Note that these two types of infrastructure depreciate at different rates in order to account for their different resilience to natural disasters. Adaptation infrastructure is able to better withstand the effects of climate change and natural disasters than standard infrastructure, and therefore δ z i > δ z a. Bevan and Adam 2016), in contrast, consider the case of operations and maintenance expenditures affecting the level of depreciation of public capital to underline the need for accounting these in the government s budget constraint. Another channel through which natural disasters can affect fiscal policy is through market interest rates. As S&P 2015) points out natural disasters can, in addition to the physical destruction of infrastructure, damage a sovereign s creditworthiness. While the real interest rate on concessional debt is held constant r d,t = r d ), the natural disaster 2 Liquidity-constrained households do not have to pay fees for using public infrastructure. 5
6 shock weakens the sovereign s rating by D r,t. And as common in the literature, large accumulations of external debt in deviations from its steady state level) aggravate the country risk premium, in line with Schmitt-Grohé and Uribe 2003). Given the riskfree world interest rate r f and nominal GDP y t = P n,t y n,t + P x,t y x,t ), the real interest rate on external commercial debt follows r dc,t = 1 + D r,t ) dt+dc,t r f + v g e ηg y t )) d+ dc ȳ. 9) In addition to building resilience with adaptation infrastructure, the government can decide to set up a fund to build up its savings against a natural disaster. Let s t be government savings in a bank abroad, paying real interest rate r f, the fund can only be drawn down in case of a major natural disaster to finance the fiscal deficit that arises with reconstruction activities. In addition to this buffer, the government can finance its fiscal deficit with external grants Ξ and a combination of tax adjustments and borrowing: external concessional debt d t = d t d t 1, as well as domestic b t = b t b t 1 and external commercial d c,t = d c,t d c,t 1 debt according to the rule 1 v) b t = v d c,t. The government budget constraint is thus given by P z i,ti z i,t + P z a,ti z a,t + Υ t + r t 1 P t b t 1 + +r d,t 1 d t 1 + r dc,t 1 d c,t 1 + s t P t b t + d t + d c,t + r f s t ) +τ c t P t c t + µz e t 1 + Ξ t. We can rewrite the budget constraint above in terms of the fiscal gap GAP ) as GAP t = P t b t + d c,t + τ c t τ c 0) P t c t s t, 11) where GAP t = EXP t REV t, i.e. given by the difference between total expenditures and revenues when the consumption tax is kept at its initial value τ c 0) and concessional debt and grants are exogenous, is covered by domestic and external commercial borrowing, VAT adjustments, and/or savings withdrawals, such that EXP t = P z i,ti z i,t + P z a,ti z a,t + Υ t + r t 1 P t b t 1 +r dc,t 1 d c,t r d ) d t 1 d t, 12) REV t = r f s t 1 + τ c 0P t c t + µz e t 1 + Ξ t. 13) The fiscal rule for the consumption tax rate allows τ c to respond to both tax and debt deviations from their target, with λ 1 controlling the response of the tax adjustment to the tax rate that would prevail if all the other financing instruments were not available to close the fiscal gap and λ 2 controlling the response to deviations from the debt target τ c t = τ c t 1 + λ 1 τ c t ) target τ c t 1 ) + λ2 P t 1 b t 1 + d c,t 1 ) P b + d c ) target y t, 14) where the tax target τt c ) target = τ0 c + GAPt P tc t, ensuring debt sustainability in the long run. 6
7 2.3 Households The economy features two types of households: Ricardian and liquidity-constrained denoted by r and c, respectively), who consume tradable goods produced domestically c x,t and abroad c m,t as well as domestic nontradable goods c n,t. The consumption basket is defined as the CES function c i t = [ρ 1 ) ɛ 1 ɛ x c ɛ ix,t + ρ 1 ) ɛ 1 ) ɛ m c i ɛ m,t + 1 ρ x ρ m ) 1 ɛ 1 ] ɛ ɛ 1 ɛ c i ɛ n,t for i = r, c, 15) where ρ m and ρ x are weights and ɛ is the intratemporal elasticity of substitution between consumption goods. The associated consumer price index is given by P t = [ ρ x P 1 ɛ x,t + ρ m P 1 ɛ m,t ] ρ x ρ m ) Pn,t 1 ɛ 1 ɛ. 16) Ricardian households face the intertemporal optimization problem max β t cr t ) 1 1 ςc t=0 1 1, 17) ς c where β is the discount factor and ς c is the intertemporal elasticity of substitution of consumption. In addition to consuming goods, this representative household invests in private tradable and nontradable capital i x and i n, respectively), which encompasses ) some adjustment costs ACj,t r = υ i r 2 j,t δ 2 k k r j,t 1; pays levies on standard public j,t 1 r infrastructure µz i ; saves through domestic bonds b; and buys foreign debt b, which carries a real interest rate r as well as portfolio adjustment costs Θ r t = η 2 b r t b r ) 2, where b r is the steady-state value of external private debt. The government levies a value-added tax VAT) τ c on consumption, which affects both Ricardian and liquidityconstrained households. The income side of the household s budget constraint 1 + τt c ) P t c r t + µzt 1 i + P t b r t + ) 1 + rt 1 b r t 1 +Θ r t + P k,t i r n,t + i r x,t + AC r n,t + AC r x,t) wt l r t + r n,t k r n,t 1 + r x,t k r x,t 1 18) + 1 r t 1 ) P t b r t 1 + b r t a R t + Υ t ) + Φ r t is composed of an employment wage w on labor l r supplied to firms; interest rates r x and r n received from tradable and nontradable capital, respectively; interest r received on domestic bonds; a fraction of remittances R and government transfers Υ corresponding to the share of Ricardian households in the labor market; 3 as well as profits Φ r from owning domestic firms. The accumulation of private capital, which depreciates annually at rate δ k, is given by k r j,t = 1 δ k ) k r j,t 1 + i r j,t for j = n, x. 19) 3 The fraction of liquidity-constrained households in the economy is given by a > 0. 7
8 The solution to the household s constrained maximization problem yields the consumption Euler equation [ c r t = c r t+1 β 1 + r t ) 1 + τ t c ] ςc, 20) 1 + τt+1 c and the non-arbitrage conditions defining that the returns on tradable and nontradable capital equate the return on domestic bonds 1 + υω r j,t ) 1 + rt ) [ Pt+1 P t P k,t P k,t+1 ] = r j,t+1 υ ) Ω r 2 P k,t+1 2 j,t+1 + [ ] i r j,t δ) + 1 δ), 21) υω r j,t+1 ) where Ω r i r j,t = j,t δ, for j = n, x, and that the return on domestic bonds equates kj,t 1 r the return on external private debt 1 + r t ) P t+1 P t = k r j,t 1 + r t ) [ 1 η b r t b r )], 22) where the real interest rate on external private debt r t = r dc,t + u is a premium u over the sovereign s real interest rate on external commercial debt r dc and η governs the level of integration the private sector has in international capital markets. 4 Liquidityconstrained households have the same preferences as Ricardian households but are prevented from saving and borrowing in the domestic and external financial market. These households have therefore to consume as much as their income from wages, remittances, transfers allowance, and pay the same consumption taxes as the Ricardian households, i.e. their budget constraint reads as 1 + τt c ) Pt c c c t = w t lt c + a 1 + a R t + Υ t ). 23) 2.4 Aggregation and market clearing conditions Labor markets clear with labor demanded in the tradable and nontradable sectors supplied by both types of households, i.e. l x,t + l n,t = l r t + l c t = l t. Nontradable output produced domestically must match the demand for nontradable goods, public and private investment used in the process of building nontradable public and private capital domestically with a k and a z defining their nontradable content) ) ɛ Pn,t y n,t = ρ n c t + a k i n,t + i x,t + AC n,t + AC x,t) + a z ii z P i,t + a z ai a,t. z 24) t 4 A low η depicts the case in which the country has an open capital account with the private sector easily borrowing from abroad. 8
9 Finally, b t + d c,t + d t + Ξ t + R t s t = [ P n,t y n,t + P x,t y x,t r t 1b t 1 Θ r t r dc,t 1 d c,t 1 r d,t 1 d t 1 r f s t 1 P t c t + 25) ] P z i,ti z i,t P z a,ti z a,t P k,t i n,t i x,t AC n,t AC x,t ), where the right-hand-side of 25) represents the current account deficit and the lefthand-side the capital account, i.e. the current account balance ca t = b t d c,t d t Ξ t R t + s t. 5 3 Calibration To be completed. 4 Results To be completed. 5 Conclusions To be completed. References Andrew Berg, Rafael Portillo, Edward F Buffie, Catherine A Pattillo, and Luis-Felipe Zanna. Public Investment, Growth, and Debt Sustainability; Putting together the Pieces. IMF Working Papers 12/144, International Monetary Fund, June David L. Bevan and Christopher Adam. Financing the reconstruction of public capital after a natural disaster. Policy Research Working Paper Series 7718, The World Bank, June URL Era Dabla-Norris, Jim Brumby, Annette Kyobe, Zac Mills, and Chris Papageorgiou. Investing in public investment: an index of public investment efficiency. Journal of Economic Growth, 173): , September doi: /s URL 5 Under a flexible exchange rate regime reserves = 0. 9
10 International Monetary Fund. The Effects of Weather Shocks on Economic Activity: How Can Low Income Countries Cope? World economic outlook, International Monetary Fund, October Humberto Llavador, John E. Roemer, and Joaquim Silvestre. North south convergence and the allocation of co2 emissions. Climatic Change, 1303): , Jun ISSN Ricardo Marto, Chris Papageorgiou, and Vladimir Kluyev. Building Resilience to Natural Disasters: an application to Small Developing States. Mimeo, Intergovernmental Panel on Climate Change. Climate Change 2014: Impacts, Adaptation, and Vulnerability. Part A: Global and Sectoral Aspects. Contribution of working group ii to the fifth assessment report of the intergovernmental panel on climate change, Standard Poor s. Storm Alert: Natural Disasters Can Damage Sovereign Creditworthiness. tech. rep., Stephanie Schmitt-Grohé and Martın Uribe. Closing small open economy models. Journal of international Economics, 611): ,
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